Hatching Startups

It’s all about scale. That is the simplest way to explain the burgeoning trend of startup incubators and how it threatens traditional Internet seed investing.

These so-called graduate schools for startups are changing the early stage equation and pressuring venture capitalists to respond.

Among the biggest changes they bring are their new short semester-like sessions and their willingness to churn out Internet and Web-based enterprise companies in numbers that would seem unprecedented several years ago.

They also fund these companies in a parsimonious manner, giving entrepreneurs a chance to get going but without turning over significant control of their companies.

At first blush, this fling with the modern incubator that has been in effect for the past 18 months might seem like a good idea for VCs. Lots of choices. Lots of competition. But what if these young businesses no longer needed to raise traditional Series A rounds of venture funding? What if they decide not to ally with venture capitalists in their most formative stage? How will VCs play in this new world order?

At issue here is one of the major lifelines of the venture industry—the nurturing of company formation at its earliest and the creation of the proprietary deal flow that turns small investments into the big wins.

If this traditional VC process is drastically altered, so is the fundamental nature of the business.

“Definitely a lot of things have changed,” says Y Combinator founder Paul Graham. “Whether VCs like it or not, the world of funding startups has changed from [old style] elephants [with few offspring] to mosquitoes” or incubators with thousands of young hatchlings.

“It’s on a different scale,” he says.

It is easy to see why the change is taking place. The costs of starting an Internet company have been falling for about a decade, ever since Dell boxes began replacing expensive servers from Sun Microsystems and open source software no longer required writing a big check to Oracle. In the years that followed, cloud-based hosting slashed bandwidth costs by a factor of 5 or more.

Now, another dramatic drop in customer acquisition costs is coming from such platforms as Facebook, YouTube, Twitter and the iPhone.

“This is like Florence, Italy, in the 14th century” says Dave McClure, founding partner of 500 Startups and organizer of the 500 Startups Accelerator. It’s an Internet company renaissance, McClure says..

This ease of experimentation is leading to higher velocity company formation and investing. Joe Hyrkin, entrepreneur in residence at Trinity Ventures and a mentor at 500 Startups Accelerator, says that so much company formation leads to higher quality companies. Within the nurturing environment of an incubator, companies will fail rapidly, but also succeed rapidly, he argues. The volume of both is higher.

But there is more to it. For several years, angels investing $50,000 to $750,000 with young founders have taken a growing share of the activity in the early stage and seed markets. In return, they offer advice and money, but do not take control, says Naval Ravikant, an entrepreneur who now co-maintains the startup matchmaking site AngelList.

“VCs used to be about bundling this advice, control and money,” Ravikant says. Now, their monopoly is washing away, and a new generation of young entrepreneurs has less incentive to turn to the big Series A round. This is especially true when they can make a nice bit of scratch selling their companies for sub-venture returns at $30 million to $40 million.

Already, the world of seed investing is feeling the impact. Venture capitalists now talk about the serendipity of coming across self-funded companies they never heard of with $80 million in annual revenue, 150 employees and solid business plans.

And they worry about lost ground.

“Part of it is a feeling they are getting squeezed out of the opportunity to participate in the earlier stages of a company,” says Eric Chin, a partner at Crosslink Capital. In such circumstance, he advises “you have to throw out the old handbook and look at the new ecosystem and decide whether you want to play in it.”

Some firms are. Crosslink is examining the way it operates and hatching a strategy to work more closely with the angels and incubators, according to Chin, although he is keeping the details close to his vest at present.

Warren Lee, venture partner at Canaan Partners, says that his firm also is taking advantage of the new incubator trend by attending incubator events and demo days, where new companies show themselves.

Canaan invested in online dating site Zoosk Inc.—most recently in late 2009 when the company raised a $30 million Series D round, bringing its total capitalization to about $40 million—after it emerged from the Plug and Play Startup Camp incubator. Even though the valuation probably was higher because of its incubator experience, the relationship with Plug and Play made the firm more comfortable with the deal.

Our goal is give them just enough money to get into second gear.”

Dave McClureFounder500 Startups

“I’ve seen a lot of things that work and some that haven’t,” he says. Mentors say their lessons can involve tips on customer acquisition, sales strategies, website design, prototype construction, code development and business plan evolution.

There also are synergies in the unified workplace that many incubators offer and which allow founders to share experiences and observations.

“It creates passion and passion builds on itself,” Hyrkin says.

During the height of the previous dot-com boom, companies such as CMGI, a publicly traded venture capital fund, which had a portfolio at one time of more than 65 companies, tried to turn startup formation into an organized, integrated corporate business. Most such ventures collapsed with the stock market. Even the high-profile Idealab, which raised a $1 billion Series D round in 2000, throttled back from a high of 270 employees in five locations to just 80 staffers in Pasadena, Calif.

Partly due to this retrenching, incubators don’t have the best track records. Just 4% of incubator startups leave to compete on their own, says Alejandro Amezcua, a post-doctoral fellow at Syracuse University, who surveyed 950 government-funded and private incubators in 2008.

Amezcua found that companies survive over the short term, but not over the long term, with the caveat that for-profit incubators have a slightly better success rate and 133% higher sales growth for their startups.

However, today there is an incubator rebirth, thanks in large measure to Y Combinator and its founder Paul Graham.

“Five years ago, Paul was seen as a crazy radical,” says Dave McClure, founding partner of 500 Startups. “Now he’s seen as the gold standard of the industry.”

Graham’s Mountain View, Calif.-based incubator stands out for its ability to identify entrepreneurial talent and advise on the details of product development. It holds three-month sessions twice a year. Y Combinator invests on average $18,000 into a startup and typically receive 6% to 7% ownership.

“Our goal is give them just enough money to get into second gear,” Graham says.

Despite the relatively small investment, Y Combinator appears a financial success. Graham boasts it has funded 250 startups with a total funding tally of about $4.5 million, and he says he has had a bit more than that returned to the organization.

Funding at Y Combinator rose a notch in January when Milner and Conway’s SV Angel created something of an index fund—an agreement to invest $150,000 in every Y Combinator startup.

Now, Y Combinator clones are everywhere. Several dozen incubators already exist and insiders expect more than 100 will be operating nationwide before long.

“I think there are going to be a lot of attempts to build Y Combinator copies,” says Tim Rowe, president of the incubator Cambridge Innovation Center.

Clones try to duplicate aspects of the model. Among them is Brad Feld’s TechStars, Excelerate Labs in Chicago, LaunchBox Digital in North Carolina and DreamIt in Philadelphia, among others. In addition, CriticalMass launched at the Cambridge Innovation Center, supported by New England venture firms Bain Capital Ventures, Charles River Ventures, Flybridge Capital Partners, Highland Capital Partners and North Bridge Venture Partners.

Another promising knockoff is McClure’s newly formed 500 Startups Accelerator, which has an emphasis on design and distribution. It will run three programs a year with 10 to 20 companies in a batch for a total of 50.

Having people together in close proximity is a big deal to McClure, an angel investor and a onetime PayPal executive. People learn from each other, says McClure, whose expansive digs at the Accelerator, with its unfinished floors and desks arranged in random huddles, are a contrast to the manicured office space of most venture firms on Sand Hill Road.

McClure is a realist, though. Failure rate could be 50% to 80% of companies, and “our internal goal is to get one-third to their next funding,” he says. That will make the numbers work. Terms are generous. Companies get $25,000 to $100,000, or on average about $50,000 at a $1 million pre money valuation.

Perhaps the most serious question facing the modern incubator is saturation.

“I don’t think there is room for that many more” given the size of the venture industry today, says Rowe, who adds a cautionary note. “There will be a shakeout.” —Mark Boslet

Entrepreneurs Feel The Love

I’ve seen a lot of things that work and some that haven’t.”

Joe HyrkinEIRTrinity Ventures

Jeffrey Rosen

’s startup Humble Bundle doesn’t have what you would call an intuitive business plan.

The San Francisco-based company packages video games from independent developers with charitable solicitations and lets users decide what they are willing to pay and how much to dedicate to charity. The company’s first bundle brought in $1.3 million; its second, $1.8 million. Rosen and his co-founder are now soaking up the adulation at the Y Combinator incubator.

“The business model sounds pretty crazy,” especially when a lot of the games are free on BitTorrent, Rosen says.

But success is success, and investors are dialing his phone nonstop.

“Before Y Combinator, we didn’t get anything like that,” he says. “Now everybody wants a piece of the company. It’s much easier to raise $2 million with Y Combinator having vetted you.”

Apparently so. These are good days for Internet entrepreneurs and especially for those who qualify for the nation’s top incubators. Rosen took $17,000 from Y Combinator in exchange for between 5% and 10% of his company. He took another $150,000 from investor Yuri Milner and Ron Conway’s SV Angel fund after the pair offered each Y Combinator startup a similar boost.

There’s also a great deal of business advice to absorb, such as the operational wisdom Jesse Pickard, co-founder of MindSnacks, is receiving at Dave McClure’s new 500 Startups Accelerator.

Pickard says he is spending a good deal of time on customer support issues and hiring for his iPhone language-tutoring app company. “I think that’s where a lot of the value comes,” he says. “The spread of these incubators really helps early stage startups get off the ground.”

Apportable founder Collin Jackson agrees. Office hours with Y Combinator founder Paul Graham helped refine the focus of his San Francisco-based company. The startup helps iPhone apps developers rework their programs for other operating systems.

But Graham’s help doesn’t stop there.

“He’s very good at introductions to investors,” Jackson says.

And that can be the real bottom line. —Mark Boslet

Poll Results: Incubators Not a Threat to VC

Incubators apparently are not all that bad.

Last month, VCJ asked readers of its online affiliate peHUB.com whether modern tech incubators that are patterned after Y Combinator are a threat to traditional seed and early stage venture investing. Nearly 71%, or more than two-thirds, voted “No.”

When asked whether they had any additional comments, most respondents pointed out that incubators are simply taking advantage of cheaper startup costs. “Startups today need less capital to get off the ground and these seed incubators are proving it,” said one respondent.

Another respondent noted: “Given the other costs of launching a new idea has been minimized because of new technologies like app engine and S3, the last cost seems to be office space/office bandwidth. If that is minimized the amount of seed capital needed by a company is much smaller.”

We then asked how important are incubators to creating deal flow. Only one-third said that they are very important. One respondent who said that incubators are very important said: “Incubators are one piece of the deal flow funnel but are important. Think of all of the YC, Seedcamp, TechStars companies that have been funded later on.”

Another person who said that incubators are only somewhat important to spawning deals, but pointed out that the failure rate of incubators is too high to ignore: “It’s not exactly shooting fish in a barrel, many incubated companies have no chance, regardless of the incubation program.”

More than two-thirds of respondents said that incubators are here to stay, rather than representing a fad. “Incubators are starting to snowball,” one respondent answered.

One person who said that incubators are a lasting changed, added: “Some incubators will be successful, some will fail… like angel investing or VCs, it’s something that has been around, and will be around, as long as there are startups.”

One person pointed out that the industry has seen the resurgence of incubators before: “Um, don’t you remember that we’ve been through this incubator mania before?” —Alastair Goldfisher